Looking for Goldilocks in Oracle's Cloud Transition

Transcription

1 February 4, 2016 Oracle Corporation Looking for Goldilocks in Oracle's Cloud Transition MORGAN STANLEY & CO. LLC Keith Weiss, CFA Stan Zlotsky, CFA Josh Baer, CFA Oracle Corporation February 4, Industry View Attractive Stock Rating Equal-weight Price Target $41.00 We continue to look for evidence the cloud transition is adding value to Oracle. Given the lack of clarity around this question, we think investors will be wary to get back into the stock before EPS growth returns. In the meantime, we try to make sense of this transition using limited information. Assessing the Value of Oracle's Cloud Transition. The multiplier equating a given software transaction done using a perpetual licensing model versus a subscription model is a key driver of both the long-term value and near-term transition impacts of Oracle's move to cloud-based, subscription services. With a higher multiple (for example $1 of subscription revenue would have been $3 of perpetual license revenue), the move to subscription adds less lifetime value and takes longer for a transition to subscription revenues to break even. As the multiple gets smaller, the transition provides higher long-term value, as license revenues are replaced with larger relative annual subscription revenues; however, a lower multiple also implies that recent base levels of demand for Oracle software have been significantly worse. Looking forward, a key challenge in assessing Oracle's subscription transition is that financial results are highly sensitive to changes in this multiple, and interestingly, Oracle management has implied two very different relationships between license revenue and ARR. On the FY 4Q15 earnings call, co-ceo Safra Catz implied a 3x license to ARR multiple when detailing that $125M in new cloud bookings in the quarter would have been around $375M, if it were booked as license revenue. More recently (at CloudWorld NYC), co-ceo Mark Hurd discussed cloud subscription revenues were 3x that of maintenance revenues. Assuming maintenance is 20% of license, this implies a 1.7x ARR multiplier (1 / (0.2*3)). While we think the actual relationship falls between these "too hot" and "too cold" figures from company management, we believe the uncertainty and complexity of the transition makes Oracle a "show-me" story, where investors will wait for the return of EPS growth to get more constructive on the stock. Finding Goldilocks. In our note Oracle Corporation: Transition Framework and 10Q Analysis Point to Modest Margin Pressure (23 Dec 2015), we modeled Oracle's cloud transition and altered the speed at which that migration to the cloud occurred, by changing the new Cloud ARR bookings growth rates. In the analysis in this note, we hold new Cloud ARR growth constant (+69% in FY16, +31% in FY17 and +25% in FY18), but change the license to ARR multiplier to assess what this says about the levels of underlying demand in Oracle's business. Too Hot: License to ARR Multiplier of 1.7x. Although creating the most Oracle Corporation ( ORCL.N, ORCL US ) Software / United States of America Stock Rating Equal-weight Industry View Attractive Price target $41.00 Shr price, close (Feb 3, 2016) $35.69 Mkt cap, curr (mm) $153, Week Range $ Fiscal Year Ending 05/15 05/16e 05/17e 05/18e ModelWare EPS ($) Prior ModelWare EPS ($) P/E Consensus EPS ($) Div yld (%) Unless otherwise noted, all metrics are based on Morgan Stanley ModelWare framework = Consensus data is provided by Thomson Reuters Estimates e = Morgan Stanley Research estimates QUARTERLY MODELWARE EPS ($) 2016e 2016e 2017e 2017e Quarter 2015 Prior Current Prior Current Q a Q a Q Q e = Morgan Stanley Research estimates, a = Actual Company reported data Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. 1

2 long-term upside, a 1.7x license to ARR multiplier would imply recent demand trends have been significantly worse than we expected. Pro forma YoY organic constant currency license growth declines slightly in FY16 in this scenario; however, as the transition gains momentum, a lower license to ARR multiplier equates to higher subscription revenue compared to maintenance revenue. The cumulative license/maintenance vs. subscription break-even point is reached in year 3 and over a 10-year period 1.7x drives 95%+ more total revenue generated and 85%+ more gross margin dollars (see Exhibit 4 ). The 1.7x multiplier implies 22% of the overall base demand transitions by FY16, increasing to 33% in FY18. Oracle Corporation February 4, 2016 Too Cold: License to ARR Multiplier of 3.0x. A long-term negative for Oracle, the 3.0x license to ARR multiplier suggests that recent demand trends have been stronger than in our base case. Pro forma YoY organic constant currency license growth increases to 7% in FY16 in this scenario, but as license to ARR multiplier increases to 3.0x, the implied subscription revenue to maintenance revenue decreases. The cumulative license/maintenance vs. subscription breakeven point is not reached until year 8 and over a 10-year period, 3.0x only results in ~11% more total revenue generated and ~5% more gross margin dollars. The 3.0x multiplier implies 39% of the overall base demand transitions by FY16, increasing to 59% in FY18. We have seen this ~3:1 subscription to maintenance ratio in other transition models, most recently at Autodesk. (see Exhibit 1 for sensitivity analysis summary) Just Right? License to ARR Multiplier of 2.5x. We believe the actual relationship of license revenue and ARR is likely between the too hot and too cold scenarios of 1.7x and 3.0x, and in-line with the 2.5x we've been using for our base case analysis of Oracle's Cloud transition. In this scenario, pro forma YoY organic constant currency license growth increases ~4% in FY16 (see Exhibit 2), 2 the cumulative license/maintenance vs. subscription breakeven point takes place in year 6, and over a 10-year period the 2.5x multiplier yields ~33% uplift in revenue and a ~26% uplift in gross margin dollars. The 2.5x multiplier implies 32% of the overall base demand transitions by FY16, increasing to 49% in FY18 (see Exhibit 3). 3 In this base case our pro-forma database licenses decline ~8% YoY in FY16 and applications dip ~20%. Looking at data from IDC, we see our analysis corroborated with an ~5% decline in databases and a similar step down in overall applications (see Exhibit 5). 5 The importance here is that the license declines we are seeing in Oracle's reported numbers are coming from database side of the business, and not just applications moving to the Cloud. 2

3 Risk Reward Transition Model Shows Pace of Cloud Migration Regulating Margins Source: Thomson Reuters, Morgan Stanley Research Price Target $41 Bull $50 16x CY17e EPS of $3.15 Base $41 15x CY17e EPS of $2.74 Bear $25 11x CY17e EPS of $2.24 Our price target is derived from our Base Case below. Increased Fusion adoption accelerates cloud revenues, while the database cycle bolsters license revenues from the technology business. EPS impacts from the cloud transition are muted by the stronger database licenses, sustaining 44% operating margins and driving EPS to $3.15 for CY17. Investors afford ORCL a 16X multiple against subscription transition impacted EPS, still a significant discount to other transition stories like ADBE or INTU. Compelling SaaS/Paas Cloud bookings growth have failed to drive the multiple expansion we've seen in other cloud transition stories due to lengthening translation into revenue growth, a larger than expected impact on the income statement from the cloud transition, and a lack of clarity on the depth or duration of those impacts. Overall revenue remains flat over the next two years and operating margins trend lower to ~43% in CY17. Investors afford a 15X multiple against this Cloud transition impacted EPS figure, although still at a steep discount to fuller transitions like ADBE, ADSK or INTU. The increasing adoption of Cloud solutions and database cycle are unable to offset the falling license revenues at Oracle, driving continued margin and EPS declines, despite the strong recurring contribution of the customer base. Forward EPS multiple stays in the low-double digits (11X) as investors are unwilling to credit Oracle for the longer-term benefits of the cloud transition. Investment Thesis Continued adoption of Oracle's organic Fusion Apps and acquired Cloud assets (Taleo, RightNow, Eloqua, Responsys, BigMachines, TOA) could accelerate growth of the SaaS/PaaS business segment in CY16/17, which partially assuages investor concerns of Oracle's competitive positioning vs the new breed of native Cloudbased companies. A customer base of ~400K drives ~80% of operating income from recurring revenue. Flat revenue growth, operating margins supported by a steady stream of recurring maintenance revenues and repurchases driving share count lower can potentially sustain low single-digit EPS growth for ORCL. Product cycles in the applications and database segments, with new cloud and appliance delivery models have the potential to accelerate growth. Thru the Cloud transition investors should be willing to afford Oracle a higher multiple than current levels (~13x). We estimate 15X CY17 EPS, a significant discount to peers going thru similar cloud subscription transitions. Key Value Drivers Cross-selling and up-selling to customer base Scaling engineered systems business Concurrent middleware, applications and database product cycles Fusion Apps driving accelerating organic cloud revenue growth Potential Catalysts Additional share repurchases Accretive acquisitions Risks to Achieving Price Target Disruptive technologies in the data management market. Rapid migration towards SaaS-based subscription application model hurts near-term optics due to ratable revenue recognition Strong competition from other secular Cloud application vendors. 3

4 Analysis Exhibit 1: Transition Trade-off: Higher Long-term Value from Lower License to ARR Multiplier Hurts in the Near-term Source: Morgan Stanley Research Exhibit 2: 2.5x Conversion Multiple Implies Pro-Forma Organic Constant Currency License Growth of ~4% YoY in FY16 Source: Company Data, Morgan Stanley Equity Research 4

5 Exhibit 3: Our Base Case Transition Scenario Assumes a Return to Gross Margin Dollar Growth Starting in FY17 (Software License + SaaS/PaaS + Software Updates & Support) Oracle Corporation February 4, 2016 Source: Company Data, Morgan Stanley Equity Research 5

6 Exhibit 4: As the License/ARR Ratio Decreases, Breakeven is Reached Faster and Potential Gross Margin Dollars Uplift Increases Over a 10-year Period Oracle Corporation February 4, 2016 Source: Morgan Stanley Research Exhibit 5: IDC Estimates of Oracle's Software Revenues Corroborate Our Declining Database and Application License Estimates Source: IDC W W Semiannual Softw are Tracker, October

7 Exhibit 6: Oracle Income Statement Source: Company Data, Morgan Stanley Research estimates 7

8 Exhibit 7: Oracle Balance Sheet Source: Company Data, Morgan Stanley Research estimates 8

9 Exhibit 8: Oracle Revenue Drivers Source: Company Data, Morgan Stanley Research estimates 9

10 Exhibit 9: Oracle Cash Flow Statement Source: Company Data, Morgan Stanley Research estimates 10

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15 INDUSTRY COVERAGE: Software COMPANY (TICKER) RATING (AS OF) PRICE* (02/03/2016) Brian Essex, CFA AppFolio Inc (APPF.O) O (07/21/2015) $13.06 CDK Global Inc (CDK.O) U (01/19/2016) $45.06 Descartes Systems Group Inc (DSGX.O) E (11/25/2014) $18.51 EnerNOC Inc (ENOC.O) E (07/30/2015) $5.26 GoDaddy Inc (GDDY.N) O (05/11/2015) $30.27 Instructure Inc (INST.N) E (12/08/2015) $17.23 MINDBODY INC (MB.O) E (09/28/2015) $11.01 Sabre Corp (SABR.O) O (10/30/2014) $25.00 Shopify Inc (SHOP.N) O (01/19/2016) $23.00 Travelport Worldwide Limited (TVPT.N) O (11/04/2014) $10.16 Keith Weiss, CFA Adobe Systems (ADBE.O) E (09/10/2010) $87.99 Akamai Technologies, Inc. (AKAM.O) E (04/28/2011) $44.39 Autodesk (ADSK.O) E (11/10/2015) $49.56 Check Point Software Technologies Ltd. (CHKP.O) U (05/27/2015) $79.77 Citrix Systems Inc (CTXS.O) U (01/19/2016) $68.09 Intuit (INTU.O) E (08/19/2015) $95.89 Microsoft (MSFT.O) O (01/13/2016) $52.16 Oracle Corporation (ORCL.N) E (11/11/2015) $35.69 Palo Alto Networks Inc (PANW.N) O (05/16/2013) $ QLIK Technologies Inc. (QLIK.O) E (10/06/2014) $25.05 Red Hat, Inc. (RHT.N) O (01/13/2014) $67.70 Salesforce.com (CRM.N) O (05/23/2011) $65.34 ServiceNow Inc (NOW.N) O (09/18/2013) $59.30 Splunk Inc (SPLK.O) O (10/06/2014) $47.00 Symantec (SYMC.O) O (12/15/2015) $19.28 Tableau Software (DATA.N) O (10/06/2014) $79.61 VMware Inc (VMW.N) ++ $44.96 Workday (WDAY.N) E (11/06/2012) $63.06 Melissa Gorham AVG Technologies (AVG.N) E (03/12/2013) $18.39 Barracuda Networks Inc (CUDA.N) E (01/08/2016) $11.59 Box Inc (BOX.N) E (02/17/2015) $11.00 FireEye Inc (FEYE.O) E (10/15/2013) $14.18 Fortinet Inc. (FTNT.O) E (10/06/2014) $26.39 Imperva Inc. (IMPV.N) E (09/10/2015) $49.59 Proofpoint Inc (PFPT.O) O (09/10/2015) $47.14 Rapid7 Inc (RPD.O) E (08/11/2015) $12.68 Varonis Systems, Inc. (VRNS.O) U (09/10/2015) $17.56 Sanjit K Singh Apigee Corporation (APIC.O) O (05/19/2015) $7.06 Atlassian Corporation PLC (TEAM.O) E (01/04/2016) $23.77 New Relic Inc (NEWR.N) O (09/10/2015) $28.37 Nuance Communications Inc. (NUAN.O) E (05/01/2013) $17.43 SolarWinds, Inc. (SWI.N) E (11/02/2015) $60.00 Stan Zlotsky, CFA Bazaarvoice Inc (BV.O) E (09/02/2015) $3.55 Cvent (CVT.N) U (09/10/2015) $24.80 HubSpot, Inc. (HUBS.N) O (09/10/2015) $39.61 Jive Software Inc (JIVE.O) U (09/10/2015) $3.42 NetSuite (N.N) U (10/14/2010) $67.10 Opower Inc (OPWR.N) E (04/29/2014) $8.23 Veeva Systems Inc (VEEV.N) O (04/02/2014) $23.50 Workiva Inc (WK.N) O (01/06/2015) $14.22 Zendesk, Inc (ZEN.N) O (09/10/2015) $21.44 Stock Ratings are subject to change. Please see latest research for each company. * Historical prices are not split adjusted Morgan Stanley 15